The Curious Case of the Missing Defaults

Usually, a sudden stop in capital inflows sparks a currency crash, sometimes a banking crisis, and quite often a sovereign default. Why, then, has the worldwide incidence of sovereign defaults in emerging markets risen only modestly?

CAMBRIDGE – Booms and busts in international capital flows and commodity prices, as well as the vagaries of international interest rates, have long been associated with economic crises, especially – but not exclusively – in emerging markets. The “type” of crisis varies by time and place. Sometimes the “sudden stop” in capital inflows sparks a currency crash, sometimes a banking crisis, and quite often a sovereign default. Twin and triple crises are not uncommon.

The impact of these global forces on open economies, and how to manage them, has been a recurring topic of discussion among international policymakers for decades. With the prospect of the US Federal Reserve raising interest rates in the near and medium term, it is perhaps not surprising that the International Monetary Fund’s 18th Annual Research Conference, to be held on November 2-3, is devoted to the study and discussion of the global financial cycle and how it affects cross-border capital flows.

Rising international interest rates have usually been bad news for countries where the government and/or the private sector rely on external borrowing. But for many emerging markets, external conditions began to worsen around 2012, when China’s growth slowed, commodity prices plummeted, and capital flows dried up – developments that sparked a spate of currency crashes spanning nearly every region.

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It is difficult to ignore that China's central bank has warned extreme credit creation and trouble in the shadow banking system could lead to a full-blown financial crisis. In response, they continue pumping out liquidity. If they don't the whole system might seize up and cease to function, on the other hand, such actions only create more problems going forward. The article below looks at how China's policies are affecting global markets.

"Venezuela's debts owed to China are understood to be in arrears" Whether you know a great part of Venezuela's debt to China is paying with heavy oil instead of hard currency, as the country is collapsing due a miserable government. Therefore, there isn't any transparent information available regarding the deals with China in this issue of debt for oil. It isn't surprising that countries that have debts with Chinese state companies/government are experiencing difficulties to repay them back, as China strategically wants countries to be indebted with them where raw materials can be secured around the world for Chinese dominance.

Yes Steve you are correct. The production cost structure is also very critical. I believe the US can equally compete with China under a different system. Take the cost of raw materials against market doctrine. Economics 101. Adam Smith's market doctrine is based on supply and demand. The underlying axiom is country X produces good X and is bought by currency X belonging to country X. If country Y wanted good X it has to change its currency Y into currency X to buy good X. That is why a Euro cannot directly buy goods from the US until it is changed into a US dollar hence Exchange Rate. But for Africa, Latin America, Asia that is not the case as seen in the London Metal Exchange. Africa's, Latin America's, Asia's mineral wealth on the LME that handles most of the world's non ferrous metals only allows the US dollar, the Sterling pound, the Japanese Yen, the Euro to buy Africa's, Latin America's, Asia's mineral wealth adding that wealth to the US dollar and the LME accepted Currencies. In 2015 the Chinese reminibi was added to the list while African, Latin America, and Asian currencies minus China and Japan are banned in this so called age of free markets and trade liberalisation. The going deeper into the LME price system. Following the free market doctrine of Adam Smith in which the forces of supply and demand determine the real value of a commodity termed as the price, the LME price structure reveals a serious imperfection. The LME for example may sell 70,000 tons of copper to arrive at a market price of US$2,000 per ton in a day. The total revenue in a day would consequently be US$140 million for copper suppliers. Accordingly Zambian mining companies naturally demand US$2,000 per ton for their copper. However looking closely at the LME price structure, Zambian mining companies may only have contributed 70 tons to the 70,000 tons of copper sold on that day on the LME. What this illustrates is that the LME prices are based on aggregate supplies of copper from many countries against a set value of US dollar liquidity giving an LME US dollar driven price. Consequently the market price for Zambian copper sold on the LME US dollar derived price should be US$2 per ton as it contributed only one thousandth of the copper supplied and thus one thousandth of the LME price. This low price can be the true value of Zambian copper when looking at a condition if the LME accepted as the only permitted currency, the Zambian Kwacha, whose liquidity in 2013 was worth roughly in US dollar terms about US$1 billion. The question is that would the LME be able to derive the same copper price of US$2,000 per ton based on Kwacha liquidity worth just US$1 billion, which has to be also used to run the Zambian domestic economy, as compared to over US$1 trillion plus a day on London's money markets? What then would be the impact on market prices and production costs in US using LME Kwacha driven prices?Behind this let us not forget the written word of the former editor of the Financial Times Mr Crowther in his book "An Outline of Money". He noted that “if a purchaser is someone who want D-marks in order to pay for German exports, the fact that he can get his marks cheap is equivalent to a reduction in the price of exports; it will stimulate sale in exactly the same way as an ordinary depreciation of the exchange rate” (Crowther (1951) p.260). China's cheapness factor is instead of following the depreciation of currency as so widely held by the IMF that forced many countries to do, China instead deoreciates the price of its commodities which does the same thing: stimulates inflows. As you so rightly said about production costs China may well not be operating some of its firms profitably against its cost structure but State support keeps them going. Again you are right in terms of production costs that cheaper raw materials produce cheaper final products. The LME issue and currency convertibility not determined by market price but by decree goes against the market system. Last the defination of imperfect competition when examined closely in simple terms says if a firm produces 10 iPhones at US$1 each a day it expects US$10 a day. But if it still produces yen iPhones a day it expects US$10. But if demand drops to 5 iPhones being sold per day the firm will still expect US$ 10 a day, but the cost of each iPhone would be US$2 being per day for the total stock US$20 per day but actual sold stock US$10 a day that the firm expects. What is observed is that they are still five iPhones left on the shelves, which means the five sold iPhones paid for the remaining five still left on the shelves. Those five appear to human perception as profit. So next time you enter a shop and find it full of goods, you pick one can of baked beans remember you are paying for another three cans of beans left on the shelve. The Theory of a firm production costs goes two ways. Therefore does discounting bring the price to the real price per unit time? What then is the purchasing power of money in all this?

The missing default assumes the US dollar value globally is the same. Yet what if the value of the US dollar is not the same? As mentioned Chinese dollars offer conditions in value terms that are not on the same conditions as Western US dollar loans. Then the aspect of global finance that has evolved into a vibrant system. Assuming the market is perfect is a gross error. The International Monetary Fund's 18th Annual Research Conference needs to evaluate how market friendly are IMF fixed cross rates. As noted the cross-rates appear day in and day out, in value terms, in many national currencies. This implies that national money markets have the same money market currency liquidity and trade volumes to produce the same cross rates as observed between Britain and the United State of America. On the February 16th 2017 the Indian Rupee traded at INR0.01495 per US$1, while the Sterling pound was at INR0.01199 per £1, giving a IMF cross rate of 1.24. The Japanese Yen on the same date stood at JPY¥0.008782 per US$1 and JPY¥0.007033 per £1 giving a cross rate of 1.24. The Canadian dollar also on the same day had CAD$0.76569 per US$1 and CAD$0.61420 per £1 to give 1.24 as it's IMF fixed cross rate. The Chinese Yuan against the US dollar stood at CNY¥0.145541 per US$1, and CNY¥0.116789 per £1, on the same day to give a IMF cross rate of 1.24. The Mexican Pesos, Brazilian Real, South African Rand, on the same day like all currencies across the world had 1.24 as the IMF cross rate fixed on the US dollar and Sterling pound.The reality on the ground is that Zambia, Britain, Canada, India, Japan, China, Mexico nor the EU has the same level and volume of trade to give credibility to the IMF fixed cross-rates. In fact, the demand of the Euro or the Zambian Kwacha, Euro against the US dollar and the British Sterling pound and other African, Asian, Latin American currencies in relation to trade, within their money markets, gives exchange rates that are outside the IMF fixed cross-rate system. There is no competition here with IMF fixed cross rates. Therefore what may define an emerging market is a market operating outside in value terms the IMF fixed cross rate system. As noted IMF MD Mr. M. Gutt at his Harvard University address on the 13th February 1948 noted that the indirect exchange rate of the US dollar to the Sterling pound was £1 per US$2.6 as US$1 equalled 600 Lire and £1 equalled 1,560 Lire, while the direct Sterling pound-US dollar rate stood at £1 per US$4. American found it cheaper buying British goods via Italy. The IMF ruled in favour of Britain as if Italy's money markets had the same inflows as London's money market. The question here is does Italy have the same supply and demand of US dollars to Sterling to give credibility to the IMF fixed cross rate system? What happens to an economy whose inflows of currency give cross rates outside the IMF fixed cross rate system? What can only be envisaged is that it is a US dollar default in one currency stream as this error can be observed in a Free Floating Cross Rate System in which price determines the degree of convertibility and a reflection of bilateral trade. The picture that emerges in a Free Floating Cross Rate System for example, may see Country Z having trade surplus with Country J as it uses Yen to convert into Country Z’s currency the Kwachas to buy copper. This creates an exchange rate of ¥1,000 per K1 as Country J uses her Yen to purchase Kwachas, Country Z’s national currency. Country Z buys very little from Country J in relation to what Country Z exports to Country J. To this, Country J uses the purchased Country Z’s Kwachas to buy copper, against which Country Z accumulates Yen in its market as the Fund as noted in Article I of the Fund Agreement is, “to assist in the establishment of a [multilateral] system of payments in respect of current transactions between nations.” Although the exchange rate in Country Z for the US dollar, based on Country Z’s market liquidity may be K8 per US dollar, in Country J it may well be ¥200 per US dollar as Country J trades more with the United States than Country Z.If a citizen in Country Z wanted to import an iphone from the United States pegged at US$500, it would be cheaper to buy the iphone via Country J, but this would in turn affect market liquidities in both Country Z and Country J money markets and hence exchange rates as exchange arbitrage operations occur. The US$500 iphone in Country Z in Kwacha terms based on its K8 per US dollar rate would cost K4,000, but through Country J the cost of the iphone would be ¥100,000 at ¥200 per US dollar, being through Country Z’s Kwacha/Yen exchange rate at ¥1,000 per K1 be worth K100, which is equal in US dollars based on Country Z’s US dollar/Kwacha exchange rate at US$12.50. At US$12.50 per iphone the United States would be on an equal footing to deal with another country called China with its cheap exports unless China’s cross-rates are lower in the countries China/United States/Country Z’s exchange rate configurations.It would then be a question of quality and finding the best value in currency arbitrage operations.The United States would still get its US$500 disregardless of the value step up or step down and the problem of external disequilibrium is addressed provided each country settled its exports in its national currencies. Therefore defaults may well be symptoms of failings to reflect the true value of the US dollar that would vary from place to place and time to time depending on the size of the market. For example, an emerging market may be more related to market dynamics. Take China. China by controlling the size of its money markets creates value. Chinese firms quote exports in US dollars but they receive payment in Chinese Reminbi. The US dollars pass through the State that settles payment with Chinese firms in Chinese Reminbi. If a Chinese firm earns US dollars it surrenders them to the Chinese government to get Chinese Reminbi. Thus if US$150 million inflows occur on the London money markets worth US$1.5 trillion a day, the inflows would have a 10 percent impact. But if the Chinese government restricted its money markets to US$150 million the US$150 million it would be a 100 percent impact in the Chinese Reminbi. As it would gain value making exports expensive, in line with Mr Crowther the Chinese reduce the price of their exported commodities to again stimulate higher US dollar inflows which inturn allows them to build huge US dollar reserves. This creates the credit China dishes out. These reserves have been loaned out on conditions that are far cheaper than the conditions of similar loans in the western world. This in effect creates a cheaper US dollar than the real US dollar. In value terms the Chinese US dollar is cheaper and hence in value terms can be called a Chinese dollar despite it looking like a US dollar physically it is a Chinese dollar. How can the western world fight "value" something that cannot be seen. If the western world is to fight China being the Chinese dollar, then it is only fighting itself. Value systems have to change if it is to fight China economically. Change means dealing with the IMF fixed cross rates to Free Floating Cross Rates and exports being paid in the currency of the country in which those exports originate in line with Adam Smith's market doctrine of supply and demand.

Yeah, but that describes people playing the market for marginal gains and that will continue whatever system you put in place. Supply and demand is therefore not clean, in fact the whole point is to try and make it sticky. The problem the US has is Americans want to buy Chinese not American and the only thing that stops that is product cost parity which is not going to happen in the foreseeable future as per Adam Smith

PS I dont doubt the mechanism you describe David but it is overshadowed by the price differential of a product made in China and the US. Your storyboard hinges on product supply to market. When Obama asked Steve Jobs about manufacturing coming back to the USA Jobs said it would not happen. Jobs is also on record as saying he needed 8,000 qualified engineers and got them in 3 months in China whereas he wouldnt even have started interviews in the USA in that time and the American engineers would not be available. The China - USA issue is about delivery, capability, compliance with demand not currency which is why Trump cannot deal with it. From a corporate manufacturers point of view its the equivalent of the Gold Rush, and the gold is in China. The middle man is the currency FX and the middle man costs are covered

But ZIRP means capital has no yield value, so capital holders are primarily interested in retention of capital nominally and will seek solutions that grant that. Although there is a desire to move away from ZIRP it has not been achieved yet and forces may drive any move away from ZIRP back to ZIRP, whatever anybody says. For the moment Hell has frozen over and its all off-piste skiing

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